What is a Credit Crunch?

The term 'Credit Crunch' is included in the Banking edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

A Credit Crunch refers to an economic malaise caused by the inadequacy of freely flowing investment capital which becomes harder to get. Both investors and banks suddenly become more choosy in whom they will loan money to. This includes corporations which are worthy of and deserving of the credit. It ultimately leads to the cost of debt products going higher for issuing borrowers. Such crunches are commonly an outgrowth of a recession. They ensure that most firms cannot borrow enough funds since lenders are fearful of rising defaults and bankruptcies. This leads to higher interest rates in nearly all cases where it occurs.

A Credit Crunch can also be referred to as a credit crisis or even a credit squeeze. These crises often trip off when some external factor beyond a mere shift in the underlying interest rates occurs. Those businesses and people who previously were easily able to get financing and/or loans in order to pay for significant purchases or grow operations are suddenly left without recourse to such critical funds. It creates a devastating ripple effect throughout the whole economy. Home ownership percentages begin to decline while businesses begin to cut back their operations since they suffer from a devastating loss of readily and cheaply available capital supply.

Such credit crunches commonly occur as a natural reaction to a period where the lenders were too lenient with their standards for extending credit to businesses and individuals. Their previous loans they issued to various borrowers who were questionable in their capability of repaying the loans in the first place. It causes the default rates to skyrocket. This then leads to an appearance of toxic debt in direct consequence.

There have even been extreme scenarios like with the Global Financial Collapse and Great Recession of 2007-2009 where the levels of bad debt grow so high that a great number of financial institutions become insolvent. This forces them to either close their doors for good or to accept help from government bailouts in order to continue funding their daily operations.

These desperate crises can force the lending standard pendulum to swing to the complete opposite side of the spectrum. Since the lenders have grown fearful of being burned for a second time, they begin to pull back severely on their lending efforts to only engage with those borrowers who possess perfect credit and so represent the very lowest potential default risk possible. When this behavior occurs, it is called a flight to quality.

Such a credit crunch invariably leads to a lengthy and painful recession, or slowdowns in economic growth to negative levels. With the available supply of credit shrinking, it becomes a self-fulfilling prophecy. Besides tighter standards of available credit, the lenders often decide to raise their interest rates in the crunch to be sure that they can obtain higher revenues from their fewer numbers of loans and customers which they allow to borrow their money.

Higher borrowing costs also reduce individuals’ capabilities of spending money to help the economy. This further reverberates into the businesses and their decisions as their sales can consequently slow down. Finally it all eats up limited and precious business capital which might have been utilized to hire workers and expand company operations.

There are consumers and companies for whom the credit crunch and its consequences will be greater than simply a higher cost to obtain capital. Such firms which cannot at all find a source of readily available capital will in the best cases be unable to expand; while in the worst cases will fail to remain a going concern. Such companies have no choice but to pull back on their various operations and to reduce the staff on their payroll. This leads to declines in productivity as well. The two conditions feed through into the leading indicators for a recession that is growing worse by the day.

The term 'Credit Crunch' is included in the Banking edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.